Wednesday, February 13, 2008

Municipal Market Is Beset By Wave of Auction-Bond Failures: “Banks including Goldman Sachs Group Inc., Wall Street's most profitable securities firm, and Citigroup Inc. failed to support auctions of debt sold by U.S. municipal borrowers, causing interest rates on the securities to surge as high as 20 percent.

Rates on $100 million of bonds sold by the Port Authority of New York and New Jersey with yields determined through periodic auctions soared to 20 percent today from 4.3 percent a week ago, after the debt failed to attract enough bidders, according to data compiled by Bloomberg. Presbyterian Healthcare in Albuquerque, operator of seven hospitals throughout New Mexico, had rates on $38.7 million of debt reset at 12 percent.”

You don’t want to hear about failures in the $360 billion auction-rate securities market. That is not good… not good at all.

“Auction bonds have interest rates that are determined by bidding that typically occurs every seven, 28 or 35 days. When there aren't enough buyers, as has occurred in recent months, the auction fails and bondholders who wanted to sell are left holding the securities. Rates at failed auctions are set at a level spelled out in the terms of the debt.

In the case of the Port Authority, owner of the World Trade Center site in lower Manhattan and operator of the New York area's three major airports, bond documents show that a failed auction would result in rates of 20 percent.”

Listen now and listen carefully: The Fed does NOT set rates. It never has and never will. It simply cannot. The Fed can barely and with great difficulty set and maintain the Fed funds target rate. That’s pretty much it. The market ultimately ends up setting all other rates. Understand that and understand it well, because that is how capitalism works.

Rates are set by the voluntary and mutually beneficial interaction of both borrowers and lenders. They settle on a market clearing rate such that both parties benefit… and the Fed be damned. Today, right now, lenders are maxed out and they have no appetite for more debt. That means they can charge a much higher rate for their money and will to discourage borrowing.

““We have seen widening spreads, reduced demand for certain auction rate securities and failed auctions, including some auctions in which Citi acted as broker dealer,” Danielle Romero-Apsilos, a spokeswoman at New York-based Citigroup Inc., said in a statement.

The turmoil in the auction-rate market is the latest fallout in a credit squeeze that began with the subprime mortgage market collapse last year and led to at least $133 billion in credit losses and asset writedowns. For borrowers, the failures mean higher borrowing costs just as the economy is slowing, threatening revenue.”

Companies are paying more to borrow now than before the Fed reduced its benchmark rate by 1.25 percentage point over nine days in January, based on data compiled by Merrill Lynch & Co. Rates on so-called jumbo mortgages, those above $417,000, have increased in the past month, making it tougher to sell properties and risking further price declines.”

First, market participants are re-pricing risk. That is to say, pricing in more and that means higher rates. Second, they’re maxed out. Their balance sheets are bloated. They don’t want to take on new loans… so they increase the cost of money to discourage further lending. The Fed? Well, bluntly put: Almost irrelevant.

“Banks and investors are demanding greater compensation for offering credit as losses mount on subprime-mortgage securities and concerns grow that ratings of bond insurers will be cut. Elevated borrowing costs mean Fed Chairman Ben S. Bernanke will have to reduce rates further to revive the economy, Fed watchers said.”

... and so cut he will. Furiously.

“Those cuts were the fastest since the federal funds rate became the principal policy tool around 1990. The Fed lowered the rate by 75 basis points on Jan. 22 in an emergency move, then by an additional 50 basis points at the regular meeting on Jan. 30.”

Disclaimer

The Financial Ninja is a collection of my thoughts and opinions about current economic and market conditions. These are not buy and sell recommendations. Use your head and do your own research. This is a forum to stimulate discussion and debate.

About Me

I started trading during the tech bubble when I was still in high school. My trading has financed my education and I have since completed a BA in Economics and an MBA with a concentration in Finance. I have worked as both a proprietary equity and fixed income derivatives trader.